Understanding Emotional Capital

Posted on November 12, 2017. Filed under: Uncategorized | Tags: , , , , , , |

Most Humans are emotional animals, and not just humans, the statement is probably true for most living species on Earth. Unlike money, emotions are hard wired in the overall design of a human being, so separating emotions from a human being is, more or less equivalent to taking out the core of what is being a human.

The driving force behind a goal, ambition, or a dream of achieving something of significance, tends to be emotion. And emotions do play key role in how committed a human is. The idea of a human being, to be in relationship with another human being is also, mostly based on the underlying emotions that humans tend to have for each other. And once they have invested their emotions in a relationship, they tend to work extremely hard to make it work.

My own understanding of a human emotion or emotions in general is still evolving. I have always felt that, humans should not be emotionally attached to their business or profession, and my rational for holding that view has mostly been based on the assumption that, emotions will comprise the ability of a human being to make rational decisions. And the evidence tends to suggest that the view may have a strong merit. But over time, my own view on the subject matter has evolved, and in the process, it has changed somewhat.

And today, I am of the opinion that, emotions are natural enhancing tools, and maybe,I need to relearn the definition and the role that emotions can play in helping humans progress. A business or a profession, whatever it might be, may lose some of the essential intensity, if humans weren’t emotionally invested in it. And the loss of emotional attachment to a business, may not necessarily mean that, the decision making process will become more rationale based.

As humans grow, so does their emotional capital. And through a process of trial & error, also commonly known as living, most human beings tend to get a better handle of their own reservoir of emotional capital. It is by learning to better utilise and understand their emotional capital that, humans can define their own success, whatever that might be. Or in other words, learning to invest your emotional capital wisely by a way of trial & error, will define where you may end up in your human journey.

So therefore, building the right reservoir of emotional capital, by better understanding how emotions can help or enhance a human being positively, individuals as well as the society at large, can learn to make better decisions, whether business or otherwise. The idea that emotions show the weak side of a human being has no scientific merit. And emotional Capital is good for your overall well-being including the financial well-being.

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When talking about the Indian economy, are we missing the big picture ?

Posted on September 24, 2017. Filed under: Uncategorized | Tags: , , , , , , , , , , , |

So the new government got into the office on the back of a pitch that was based on a lot of hope and promises, and while I have been personally quite supportive of the need for change. I have never been in any doubt that, the changes will require time and government will have to let down people. In a country like or anywhere else for that matter, a government gets elected mostly on perception built around the hype. Average people are simply unable to breakthrough each policies and make sense of it. A country like India needs a complete overhaul of its existing economic and financial infrastructure , and that requires a lot of re-wiring and also redesigning of the entire system. Any good reforms takes time, and a prudent policy is always, to not overload the system with Big Bang reforms, one after the other, the changes have to be incremental, but constant. A system overhaul takes time, and you can’t expect the system to start firing on all cylinders right away especially when you are creating more capacity in the old system.

But economic policies alone can’t re-wire the system, it also requires better execution. And if we are talking about creating growth then, there should be a realisation that, without the ability of funding, government policies on their own aren’t the magic fix. So I don’t care what economic policies the government can come up with, driving growth in a country like India , where almost 80- 90% financing is sourced from banks simply isn’t going to work, unless and until the banks are back in shape. The fact is, the bad loans problem hasn’t been fixed, and the lenders have been too slow to offload the garbage sitting in their living room, yes there are legislative policy changes and reforms to help the banks, but banks haven’t been proactive enough. And a lot has to do with the existing training as well as mindset of the executives within the current banking system. For example, based on my own experience, I have realised that a sizeable percentage of the senior bank executives in India aren’t willing to make tough decisions, because for them, as I understood it, it’s all about a peaceful retirement and self preservation. And the investigative agencies haven’t helped decision making process either. Also some of the rule changes don’t really help the banks clean up their balance sheet. The asset reconstruction companies or ARC as they are known in India are, like a time bomb waiting to explode . On practicality basis, there is almost zero value in the ARC structure.

Without recycling the rubbish, you can’t get rid of the stinky garbage, and monetise it. Many quality ideas are simply not getting funded in India, and young entrepreneurs who could drive growth are more or less shut out from funding. And the other real issue is that, like European banks, the Indian banks are also now scared to lend. The ex RBI governor did good talking and provided public opinion on almost everything, but failed to provide real solutions, and now he is busy promoting a book.

I would prefer a wholesale reform of the financial infrastructure of the Indian economy, where capital market becomes the largest source of capital and not the banks. The regulators also need to support the government by unburdening the system from socialistic era policies. Also the government needs to do more work and talk less, there is too much distraction. A lot of announcement, but not much is getting done. Media channels have an endless lineup of experts, who probably wake up everyday, ready to provide new round of expert opinion. And the quality of journalism is rubbish, where is a decent discussion on, what reforms need to be brought in, to help the nation grow? The issue is everyone is drinking from the same source, whether you are the federal or state government, central or state government owned companies, or the private sector. And unless there is new liquidity going into the banks, it’s going to be tough to fund growth.

Various state governments across India are struggling with a very bloated fiscal situation, and they also own companies that have not made money for a long period of time, so it doesn’t make any good business sense for these states, to continue to own unprofitable companies. And in most cases, these companies are competing with other unprofitable or distressed state owned companies across India. These companies were set up in various states across the country, to provide services to the citizens, and by design they were probably never pushed to make a profit. But the time has come for states across the country to find an exit, by either privatising the companies or merging them together with similar companies in other states, and then exiting it. This will also reduce the debt burden on the states.

Also to fund growth, I will encourage the government of India to put in $ 3 billion in equity and then raise additional $ 7 billion from local banks as well as international investors/ banks, to create a growth and investment fund. This fund could also be made tax exempt from withholding taxes for foreign investors, and let this fund buy new loans from the banks, the fund could then repackage the loans in an asset backed security ( ABS) as a way to refinance itself. The fund could also provide working capital loan indirectly to the SMEs through the banks, and let the originator banks hold just 10% of the new loan on their books. RBI could also buy some of these securities from the secondary market to improve the liquidity and pricing. Also Emerging market focused fixed income investors could buy into these securities, and will be exempt from any withholding taxes. I am not a great fan of using pure debt to finance infrastructure, I would rather first raise equity to fund the infrastructure, and then give equity investors an exit by issuing the debt. If you look at it from pure risk perspective, the equity investors are in fact protected from the completion of the underlying asset, and that’s why you need a strong construction company to provide completion and construction risk coverage. So once the asset is built, equity investors will have their value protected, and the return will come from issuing the debt at a premium. There is a natural cycle, and any insurance cover to protect your investment in infrastructure asset will not work, if you simply buy a credit protection. I prefer a equity – debt- equity – exit cycle , which is based on water cycle of cloud – liquid water- ice – water – cloud. That’s the best value preservation model.

The idea that you can protect your asset for its entire life cycle carrying just debt is completely absurd, and it simply doesn’t work, any debt, if not managed well tends to have the natural tendency to end up spiralling into an unsustainable burden. And, if there was no refinancing then, most debt will not be repaid. You can repay debt from cash flow, but refinancing still remains the most frequently used tool. So we need to link the cycle especially for infrastructure assets. The issue with an infrastructure asset also is the permanent loss of value, and this is when the asset becomes redundant for a number of reasons, but if as an investor, you haven’t recovered money during the cash flow generation lifespan or lifecycle of the asset then, you are looking at a permanent loss of capital.

 

 

 

 

 

 

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The statistical data and the design of the modern economy

Posted on July 6, 2014. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , , , , , , , , |

Our modern economic system is overload with all sorts of statistical data, all aimed at helping us better understand and interpret, the overall health and condition of the economy. And one of the top leading economic indicator to measure the health of an economy is the Gross Domestic Product (GDP), used by central bankers around the world to adjust their monetary policies, by the governments to create economic policies and by the markets to make economic assessment in order to make investment decisions.

So how is our world doing ? well, based on the international comparison program ( ICP ) data for the year ending 2011, the PPP- based world GDP is over US$ 90 trillion. And around 32.4% of this GDP comes from the six Middle income countries including of China, India, Brazil, Indonesia and Mexico, while the six high income countries including of US, Japan, Germany, France, UK and Italy make up around 32.9% of this PPP-based world GDP. The average per capita income of Qatar, Macau, Luxembourg, Kuwait and Brunei of around US$ 100,000 is much higher than the six high income countries, and the US being the cheapest in terms of living cost among the high income countries. And EGYPT, Pakistan, Myanmar, Ethiopia and Lao rank among the cheapest economies in the world.

In terms of investment expenditure, China now has the largest share of the world’s expenditure for investment in other words gross fixed capital formation, and roughly 80% of Asia’s ( including the pacific region ) investment expenditure comes from China and India while Brazil makes up 61% of South America ‘s overall investment expenditure.

But for many, all this is might not only be quite boring statistical data but also somewhat irrelevant as they may not be able to relate to it or interpret it. On the other hand, many would find and consider these vital statistical data extremely important as it confirms ( their interpretation ) that our world is getting a bit richer than it was over a decade ago but then some may disagree especially those who are still struggling to keep their head above water after the financial crisis of 07/08, and would rightly argue that rich are getting richer and the income gap is expanding.

Whatever may be the case, these statistical data are nothing but a rough estimate prone to error. So far we have not managed to design an efficient economic reporting system that is able to account for all (100% ) of the economic activities of the world.

So whichever way, we decide to measure or calculate, how rich our nations economy or the world is getting, there will always be an element of misrepresentation of the actual fact. And I believe Simon Kuznets, who developed the idea of using GDP matrix to measure the size of a country’s economy knew about its limitation. This is why Kuznets extensively wrote about its use and abuse. And one of his statement in 1962 more or less sums up the issue. He said,  ” Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what “

Antarctica has trillions of dollars worth of natural resources but zero GDP because it is the people and their economic activities that is what a GDP calculation is tying to measure. So it is the people who make the economy as well as the GDP number, and without people, there is no economy so quite clearly, a economy should be built around people and not the other way round.

The economic literacy of the world population is extremely low, and people on the street today couldn’t be more connected to the financial world than ever before, as evident from the immediate after of the financial crisis. And increasingly more people are starting to talk and pay attention to economic issues that has already affected them directly or indirectly or may affect them going forward as consumers, investors, citizens and what not.

So the design of the modern economy should also incorporate providing basic and essential economic literacy to all the participants and users of the system. A higher rate of basic and essential economic literacy will help people around the world better understand the complex economic system. Economics and overall health of an economy affects people in different ways, and its influence on people’s life is ever increasing so there is strong case for the system to be upgraded, and designed around people, to make it work better.

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The Tax Debate: There is a lot more to an economy than taxes

Posted on July 26, 2013. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , , |

The OECD recently launched a scheme to combat tax avoidance and evasion related issues from both major multinational corporations and individuals. The initiative called base erosion and profit shifting ( BEPS )  plan was presented to G 20 finance ministers on the 20th of July this year on their request.

In short, the BEPS report confirms OECD’s findings that the existing international tax system is failing the rich as well as poor countries. This is more or less stating the obvious. Taking the initiative further during a recent announcement the OECD has also identified 15 policy action points that it hopes will restore trust and fairness in the system. In principle, the scheme does seem to hit the right notes especially with law and policy makers and hence it was fully endorsed by the G 20 finance ministers this month.

The OECD’s action plan on base erosion and profit shifting (BEPS) will most likely be considered by many as a step in the right direction but it does seem to be loaded with complicated ideas to help nations find ways to collect more tax revenues from major international corporations as well as individuals. And while it rightly focuses on tax treaties, tax compliance, overall tax policies among other things to fix the inefficient global tax system, parts of the scheme may not be fair for all and also falls short on addressing the real issues. For example under the planned proposal OECD recommends a multinational treaty aimed at tax avoidance but this treaty could also potentially hurt smaller countries that are using low corporate income rates to attract investments from across the world.

Also after looking at the bigger picture it will be unwise to conclude that the downward trend in tax income revenues is all simply down to deliberate tax avoidance and evasion by major corporations and individuals. But here is something interesting, according to the US government agency data for the financial year ending 2011, the US corporate tax collection was roughly around 2.4% of its GDP. And the historical data suggests that the overall corporate tax contribution  has shrunk dramatically since 1950s but its not just a US problem as most OECD economies collect between 2% to 3% of their GDP in corporate income tax revenues. However, there are no clear evidence to suggest that this downward trend is all cause of corporates tax avoidance and evasion. There are serious existing policy issues related to taxation thats need to resolved and unless the lawmakers take radical measures to reform the existing tax systems even if OECD’s scheme was to be fully implemented it’s hard to project a significant rise in the overall corporate tax income revenues in terms of percentage of the GDP but we will have to wait and see.

Over the past few decades there has been a significant shift in the overall distribution of the tax burden. For example from Oct 1, 2010 to Sep 30, 2011 the US government collected $2.30 trillion in tax revenues of which 47% was individual income taxes, 36% social insurance taxes and just 8% in corporate income taxes along with 3% in excise taxes, 1% custom duties, 0.3% estate and gift taxes, and 4% in other taxes. So clearly from the overall tax distribution stand point it is evident that the US households are bearing the brunt of the tax burden. But again this is not just a US issue for example Europeans overall tax burden is estimated to be over 15% higher than Americans or Asians for that matter. And this shift in tax distribution burden has happened over decades so its not a new phenomenon and while the law and policy makers may find it easier to criticise the corporations, it is not the corporations who make or create tax policies.

The focus of the law and policymakers of G20 countries should be around finding ways to harmonise and simplify taxes across the board as most tax systems are extremely complicated and also work with major corporations to create incentives for them to make sure they pay a fair share in corporate income tax. The world has changed and will continue to change and going forward a good tax system will need to be constantly updated and forwarding looking. Any system that is seen as Tax grab and simply aimed at taking more cash out of the private economy will most likely struggle in the long run. The system needs to be redesigned to look and feel fair and this should clearly be the focus and aim of law and policy makers involved in the ongoing tax debate.

However,the recent steps taken by various governments around the world especially the European as well as the US government has been more or less front loaded with measures to increase the tax burden on the existing tax payers. And the temptation to find ways to collect more tax revenues is understandable as most governments are under severe pressure to find ways to fix their stretched fiscal position but the law and policymakers should also realise that there are already too many hidden and indirect taxes that really affect people’s standard of living. 

And also while higher taxes or finding new ways to increase tax revenues from the existing pool of tax payers in order to pay down the debt may seem as an easier option there needs to be a realisation that the current deficits weren’t caused by corporate and individual tax evasion and avoidance. The law and policymakers do need to realise that there is a lot more to an economy than taxes, and there are no perfect economic or tax systems and probably never will be but without growth most countries will continue to struggle. Also continuing to tap more from the existing pool without enlarging it or cutting down on the overall expenses to a sustainable level is a high risk  plan so the G 20 finance ministers will do well to keep their focus on finding ways to take collective measures to boost the global growth in order to generate more income.

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The Market’s Obsession With Credit Rating and Rating Agencies

Posted on February 27, 2013. Filed under: Uncategorized | Tags: , , , , , , , , , , , |

We live in a complex and ever changing financial environment where the role and behaviour of the financial markets as well as its participants is under constant scrutiny like never before. And while the worst of the CRISIS is now behind us a post-crisis world economy is still struggling with a weak growth prospect. Although most banks in Europe as well as the US are getting back in shape and the corporates seem to be holding abundant cash it isn’t trickling down to benefit the real economy. This by no means is unexpected or a surprise and there are a number of reasons and factors at play and one of them is the financial health of governments around the world especially in the developed world as reflected by the downgrades in credit ratings of countries like the US, France, the UK, Spain among others with few exceptions.

Economic growth requires investment and risk taking and clearly the market isn’t delivering on both these issues yet. The markets obsession with credit rating and rating agencies comes from our love for playing the blame game and also our inherent nature of running away from taking responsibilities for an undesired or bad outcome from the decisions we take or have taken. The reality is everybody fails and we all know how badly the rating agencies failed.

Credit is not STATIC and by it’s design dependent on many variables so projecting it’s behaviour over a period of time requires much more than a financial model that incorporates an anticipated change or changes in the business cycles of a specific sector or an industry as well as trends and events going forward. And since most of us don’t have access to a crystal ball understanding a CREDIT more often than not comes down to developing or possessing a GOOD JUDGEMENT. So I always encourage my friends and colleagues to rely on their own judgment skills rather than paying for a borrowed one from a rating agency.

A good investor or a smart money manager should never try to justify buying into a bad investment by saying that they relied on a credit rating report issued by a rating agency. Risk and rewards generally do go hand in hand but not always and this is why I believe that it is important to look at the bigger picture and to get some perspective we should take a page out of the human history. Humanity has survived many crises and also in the process managed to put a man on the moon, explore mars and has a remarkable list of achievements and accomplishments because of its ability to evolve and take risks. Investment is not all about possessing amazing analytical skills. In my own opinion there is much more to it so I would say this Take Investment as an ART form and learn to enjoy your art as a passionate ARTIST would and with time who knows you may create your own masterpiece.

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Infrastructure Financing: Tapping into a diversified Funding Pool

Posted on January 16, 2012. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , |

As a key asset infrastructure is one of the most important driving force of an economy and has a direct impact on the overall growth and development story of the country. Infrastructure assets support a wide range of systems in both public and private sectors without which the industrial society of today simply won’t function or be as efficient. Generally developed world tends to have better infrastructure than emerging economies but having said that the overall spending on infrastructure in GDP terms by developed economies have been declining recently whereas the emerging world has increased its overall spending on infrastructure. In a fast growing economy you would expect the demand for infrastructure assets to increase immensely year-on-year and the opposite is true for a slow growth economic environment.

 So the state of a country’s economy certainly plays an important role in infrastructural needs of that nation. Infrastructure assets should always be forwarding looking because the rapid growth in population and economy especially in emerging countries will put strain on the existing infrastructure creating bottlenecks relatively quickly but at the same time parts of the countries experiencing lower or minimal growth may create a situation of overcapacity.

 Conceiving a smart and forward looking infrastructure asset and supporting it with the right capital is always critical.In the past federal, state, local tax bases other funding sources have been used to pay for vital infrastructure projects across the world. We have seen the business model for developing and funding infrastructure assets evolve in the last decade where a number of high profile infrastructure assets were built and paid for through Public Private Partnership or Initiative ( PPP or PPI). Although a number of high profile PPP projects have failed this model of developing and financing infrastructure projects is still considered one of the best way to pay for it.

 While emerging economies have the need to keep building vital infrastructure to support their growth and improve the living standards of its citizens, the developed nations especially the US are sitting on an aging infrastructure that needs to be updated. All this requires capital and with the ongoing financial CRISIS it is getting harder to source funding for infrastructure assets as banks are still struggling to fix their balance sheet. Also the asset-liability (ALM) mismatch is one of the major defects in the traditional business model followed by banks today which makes it tougher for them to commit more resources towards financing infrastructure projects. Most infrastructure projects require long term capital commitments ranging from 7 to 20 or more whereas banks own source of capital ( i.e. deposits) tend to be of much shorter tenure ranging between 1 to 5 years or less. There are also regulatory issues including of the overall exposure to the sector and the credit risk rating of the asset which limits the ability of traditional banks to commit capital. Alternate source of capital providers including of hedge funds dedicated to investing in infrastructure sector as an asset class tend to prefer investing in liquid assets and in most cases their exposure to the sector is limited to owning stocks or debts of listed utilities, toll road operators, constructions companies, ports operators among others.

 There is a strong need to diversify the source of capital base by making infrastructure an appealing asset class to a wide range of investors especially when governments including of developed as well the developing world are targeting infrastructure spending. Recently the ministry of finance of India announced an initiative called Infrastructure debt fund as to way to attract capital into the sector. This is a step in the right direction but having said that the proposal doesn’t address the core issue facing prospective investors when looking at infrastructure financing opportunities. The government of India is targeting an investment of over US$ 1 trillion ( around 10% of GDP) on infrastructure in its 12th five year growth plan for the country and the expectation is that the private sector’s share will be 50%. It is no doubt a highly ambitious plan and through Infrastructure debt fund the government’s objective is to facilitate the flow of capital from public and private sectors as well as foreign investors into infrastructure projects in India. The government figures suggest that there is a funding gap of over US$ 135 billion and this is based on the assumptions that there will be as much as 50% budgetary support for the planned investment in its recently announced 12th five year plan and the policy & regulatory reforms will mobilize over US $174 billions. Looking at the state of infrastructure in India and the balance sheet strength of the local banks it is safe to say that in reality the funding gap may be much higher than government’s expectation.

 In the developed world, UK chancellor has earmarked over GBP 30 billion in infrastructure spending in his speech delivered to the British parliament in November of 2011. The UK treasury is hoping that two-thirds of its earmarked for infrastructure investments will come from the National Association of Pension Funds and the Pension Protection Fund. It is also seeking investments in infrastructure from insurance companies and from China. The United States will need to spend over $2.2 trillion on updating and developing infrastructure assets across the country over a period of five years to meet the current needs and around $1.1 trillion of the overall spending would be new. This is according to the American Society of Civil Engineers (ASCE), and while private sector is expected to make its contribution most of the heavy spending will have to come from the government as evident from the previous spending on infrastructure in the US. The Congressional Budget Office figures suggests that the federal government, state and local governments spent over US$ 312 billion in 2004 on just water and transport infrastructure in the United states with very little contribution from the private sector.

 The current state of the global economy makes it extremely difficult for infrastructure projects to get funded. In markets like China banks are over exposed to the sector by lending to local government financial vehicles (LGFV) and most local governments are sitting on bad projects that aren’t making money and have also created overcapacity. There is also a lack of an efficient and developed secondary market for infrastructure loans in emerging market economies especially in countries like India, making it difficult for both public and private sector banks to refinance their loan books and in most cases the banks are as the end users of credit by holding the asset on their balance sheet until maturity   therefore becoming super exposed to the sector and minimizing their ability to grant more loans. Also Indian banks have recently been running a daily deficit of over INR 1trillion per day for the past few months causing a systemic liquidity deficit in the banking system further limiting their ability to commit more capital to the sector.

 Considering the above, Infrastructure debt fund (IDF) initiative of the ministry of finance of India does sound like an idea whose time has time come as it proposes to offer banks a platform to help refinance their existing loan book and by means of credit enhancement also be able to tap into low cost long term funding sources including of Insurance and pension funds. Having said that Indian banks will be competing for capital with their peers and there are no guarantees that foreign pension and insurance funds will pick Indian infrastructure assets over others. Money has no nationality and most investors will need to understand the structure better before committing capital. According to the public information released by the ministry of finance of India, the proposed IDFs will either be formatted as a mutual fund or a non bank financial company under modus operandi set out by the regulatory agencies including of SEBI and RBI.

 Although the case for IDFs has merit going forward the structure will have to evolve incorporating the realities of the market. Besides IDFs other plausible long term, simpler and sustainable solution will be for banks to set up their own independent infrastructure investment companies or in a consortium with credit guarantee agencies, construction & development companies, Institutional investors, regional development banks, multilateral agencies, utilities among others. As the promoter of the “ Infra Investment Company(IIC)” banks will inject their existing infrastructure assets and loan books along with the cash flows ( from the projects) into the balance sheet of the company and other founding partners will provide seed capital (in cash equity) of around 10% to 15% of the assets held by the company in order to secure a strong rating and valuation. The Infra Investment company(IIC) will have fixed and guaranteed revenue stream coming from existing infrastructure assets it owns and it will be relatively easier for such a company to secure a credit loss insurance cover on its pool of revenues further protecting its cash flow.

To access a diversified pool of investor base the “IIC” could do dual listing in local and foreign markets, issue bonds in local as well as foreign currency supported by its balance sheet and the strength of its credit rating. It can also act as a platform to deliver infrastructure related credit and assets to end users including of pension and insurance funds. Also through the “IIC” institutional investors such as pension and insurance funds could commit new capital into the sector removing the need for them to hire a fund or portfolio manager to manage their investment in the infrastructure sector across various asset class.

 Infrastructure assets are a vital support pillar of any economy and though some investors may consider the sector boring, good Infrastructure investments does create a positive cycle of growth, providing essential networks and services, stimulating economic growth and improving the standard of living for current and future generations. Also the investment in the sector tends to be less volatile than any other publicly traded securities.

 Although the Infra structure Investment company may not address all the existing issues in the sector but by adopting a flexible strategy the “IIC” should be able to tap into a wide range of funding pool including of retail equity investors, institutional investors, sector focused investors among others. It provides an opportunity to Investors who in principle do like infrastructure but are reluctant to buy into it because of the lack of liquidity that comes with it.

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Innovation,Ideas and the Search for Growth in a market disconnected with the Real Economy

Posted on September 14, 2011. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , |

The Best Innovative Idea can come from Anywhere Today.

End users need, market demand, availability of new technology and the search for growth are some of the Key driving forces behind innovation. FOR example Africa out of necessity is becoming the testing ground for new and innovative mobile banking experiments. The ongoing innovation in mobile payment and mobile banking is filling the growing demand generated from a part of the population that was once excluded from the economic activities and considered untouchables by traditional banks. Today mobile phone is allowing people to participate in the demand side of the economy. These mobile banking experiments could potentially change the traditional banking as we know it.  And going forward traditional banking models where if you were poor you are excluded will find it very hard to survive if they don’t adapt to the changing world around them.

Consumer lead innovation generally has a higher degree of success rate as it allows the corporate and entrepreneurs to fill in a growing demand.  Companies as wells as governments across the world have realised that innovation and technological advances are key to their long term sustainable growth.

While corporates are driven by profit, the governments have an important role to play in creating a platform that allows and encourages real value ADD innovation. The governments need to work very closely with companies, entrepreneurs and provide a supporting framework which facilitates Innovation and with it Research & Development (R&D).

Today the policy makers in the developed world find themselves aggressively competing with their counterparts from the developing nations in order to make sure they don’t lose the competitive advantage but who is to say that the NEXT BIG THING won’t come from a developing nation.

Technology has changed the world around us and without it some of us will struggle to carry out routine work. We live in a world of Facebook, Twitters , messengers, youtube and the list goes on. Today our world is so interconnected like never before. And there are legitimate concerns about the impact of ideas like Facebook, Twitter etc on the society. Going forward the society, the policy makers will continue debating the pros and cons but we can all agree that there is no turning back the clock.

The success of ideas like facebook is in its approach to innovation and its application. The scope of applications of a technology or innovations in terms of scale is far greater today than ever before.  Technologies and ideas that had more than 90% chance of failure some 10 years ago are in fact a SUCCESS story today.  Technology is evolving and in some cases too fast with significant affect on the society and the world around us.

Going forward Innovation and technology will be Key to success for developing countries especially economies and societies like China, India who run the risk of chocking on their own growth. For R&D Companies especially in Green Technology demand from countries like China & India will be at the forefront of their business strategy.

We have already seen the fast paced evolution in green technology especially in Wind and Solar.  Today the world wide wind capacity stands at around 251’000 MW and growing while the Photovoltaic production growth has averaged around 40% per year since 2000 and the installed capacity reached over 16 GW in 2011. Going forward the cost of power generation from green technologies like wind & solar will decline steadily as the technology gets better and more efficient.

The demands from developing countries for cleaner, cheaper, smarter, efficient and better technological innovations & ideas are coming out of sheer necessity and NECESSITY IS THE MOTHER OF ALL INVENTION. This growing demand will serve as a breathing ground for innovation. So it is highly plausible that the next BIG IDEA could come from the developing world or could be created for the developed world. And in order to make the most from the available opportunities companies, entrepreneurs, innovators will need to be based in markets that are generating the underlying demand.  The governments in the developing world including of countries like China and India will need to work closely with all the participants and provide the required and essential support to harness innovation and new ideas.

Some of the things the governments in the developing world could do to encourage innovation:

  • Tax breaks over medium to long term to companies, entrepreneurs, innovators
  • Encourage state or privately held companies to acquire R&D companies overseas to fast track innovation. Burning cash on duplicating the efforts already made by others in a competitive R&D environment may not be worth a while exercise.
  • Promote Innovation & technology knowing well that (R&D) is a risky investment but this risk profile can change overnight with a single EUREKA moment.
  • Promote Innovations and R&D that adds real value to the economy and bring simplicity with it
  • Pick and target sectors where it can create a niche and support it by domestic demand.
  • Have a collaborative approach to mitigate the risk profile of the development phase of a certain technology hence enhancing the return on investment
  •  Be willing to share the development risk with the private sector
  • Help with hand holding where necessary including with the implementation of the technological innovation in the market
  •  Open the market to competition  attract overseas R&D Companies and support them with funding, risk sharing and establishment of a market ( if the underlying demand is not sufficient to support the bottom-line) by creating smart legislation and work with regional partners

While innovation and technology are going to be one of the Key drivers of sustainable growth it will be unwise to assume that all the innovations will add real value and provide growth. There are Innovations that add real value to the society and meet the growing needs and demands of the population but there others which may have an impact on the society but their real VALUE ADD is debatable.

Innovation and technology is a risky venture and not all of them will go on to become the NEXT BIG Thing. We live in a world where a company like Facebook with an estimated revenue of around USD 2 billion ( FY ending 2011 ) is valued at over US 100 billion and Twitter carries a valuation tag of around US 10 billon with an estimated revenue projection of approximately US 110 million ( FY 2011 ). Incredible valuation for private companies that may or may not exist after 30 or 50 years but whether or not we agree with the valuation and the methodology used for valuing these companies the fact remains that some in the market are happy to pay the price tag on these companies and ideas.

 In January of this year Goldman Sachs and Digital Sky Technologies (DST) paid US $ 1.5 billion  this investment valued the social network company at US 50 billion, a record valuation for a privately held company. Few months later General Atlantic purchased 2.5 million shares of Facebook valuing the company at US 65 billion.  The valuation jumped by over US 15 billion is less than 3 months without any fundamental improvement in the bottom-line of the company.

Growth projections of a business are mostly an estimated guidance but using it as a KEY ingredient in your valuation methodology is pretty much like assuming that a person is tall by looking at their shadow. The numbers are only as good the people who create and make them so it is unwise to take them as the gospel set in stone.

There is a strong disconnect between the real economy, society and the market. And the problem is if any of these overpriced investments go bad the market and the media will report this as the bursting of technology bubble depriving good and essential innovative idea & technology of capital. And the technology sector will become a no go area again. We saw a bubble burst in the 2000s and its aftermath.

 A sector could go from being attractive and undervalued to be overvalued in no time depending on the speed and the amount of capital flow it gets from investors around the world. There is a strong temptation among some in the market to ride on an in fashion trend and jump in the bandwagon. For example if emerging market is the growth story we are all tempted to ride it but the logic says if a country is growing at 9% percent it doesn’t necessarily mean that all the sectors of the economy are growing and attractive so committing capital based on the overall growth story is not just ill-advised it is how we build bubble and distort the reality.

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The CHINDIANS – Reshaping the future of the global economy

Posted on April 22, 2011. Filed under: Uncategorized | Tags: , , , , , , , , , , , |

Indo-China Trade has been growing at over five times the rate of world trade growth. Going forward their increasing economic strength and bilateral trade will create a super growth corridor where the world could plug in.

China and India are now leading economic stories on the world stage and this story may very well last through most of our life time.  And while some in the market regard the two countries as competitors in the years to come collaboration and not competition will take the centre stage. India and China’s trade relationship is historic going back 2,000 years under the thriving Silk Road trade. Relationship between the two countries has been thorny in the past and they did go to war over a border issue in the Himalayan region in 1962 which affected the trade and bilateral relationship negatively.

However from the 2002 onwards when the two countries agreed to work on normalising the relationship and spurring commerce, the bilateral trade between the two has steadily grown from a mere US$ 7.3 billion in 2003 to around US $ 62 billion in 2010 growing by more than 8.4 times in just 7 years at an annual growth rate of over 120% making China the leading trading partner of India, and India jumping 11 places from 20th top trading partners of China in 2003 to be ranked 9th among China’s leading partners in 2010. The two countries have already agreed to push the bilateral trade to USD 100 billion mark by 2015. Although China’s bilateral trade volume with ASEAN, Japan and South Korea is higher the annual growth rate of the INDO-CHINA bilateral trade is far greater and is set to continue as business to business contacts grow. Also the size of the economy, population and the geographic closeness of the two countries provide abundant opportunities for growth in bilateral trade.

Today a significant portion of the world trade growth is coming from China and India. And this trend is set to continue going forward. Intra – Asian trade has clearly been one of the biggest beneficiaries of the growth. According to IMF the interregional trade flows within Asia has grown at the rate of over 13.4% from 2000 to 2009 and is estimated to be valued at just over US 1 trillion. So far China has been the major driving force behind the interregional trade growth. And a noticeable change in pattern has been the increase in imports from Asia to meet the domestic demand coming from Chinese consumers whereas previously a bulk of the imports from parts of Asia were assembled in China and re-exported to the developed markets. The pickup in domestic demand is line with the government’s attempt to rebalance the Chinese economy. In its recent 12th five-year plan Beijing has set out a clear plan and set of measures to rebalance the economy and drive up domestic consumption.

The Government in China has realized that a vibrant domestic market is the only guarantee of a sustainable growth and long term success and relying heavily on foreign demand makes the country vulnerable to external shocks . So expanding domestic consumption is clearly a favoured long-term strategy for Beijing especially when its export based manufacturing seems to be slowing down and gradually may lose competitiveness mostly driven by rapidly rising high wages, higher input cost, shortage of low-skilled workers among others. Various projections suggest that the working age population in China will peak around 2015, so the labor supply is going to gradually decline and push up the wages even higher.

Historically wage growth and household income in China have not matched the overall GDP growth and some research suggests that in fact wages have actually fallen from 53.2% of gross domestic product between 1992 and 1999 to 49.7% between 2000 and 2008. So in its efforts to rebalance the economy the government has taken measures to allow significant rise in wages across the board. In line with government policy the municipalities across China have raised the minimum wage on average by over 20%.

Rising wage pressure, appreciating currency and high input cost driven by inflation may be enough to shut down a significant number of export houses in China especially in the low manufacturing sector where exporters’ average margin is around 3% or less.

Going forward the government in China will have to look at creating policies that will allow private sector to play a bigger role and drive the domestic demand. Having that said it is worth noting that since 1999, the share of State owned Enterprise (SOEs) has declined from 37 percent to less than 5 percent in terms of numbers, and from 68 percent to 44 percent in terms of assets as a result of the SOE reforms carried out in the past under “grasping the big, letting go of the small” strategy. That said still a huge portion of the Chinese economy ( in terms of GDP ) is under government control and it has been the major driving force behind the overall GDP growth whereas the private sector has been driving India’s growth.

 It is estimated that over 80% of the Indian economy is now in private hands and the private sectors is driving the investments story in the country. Private sector in India has benefitted hugely from the Indian growth and has accumulated significant wealth. It is estimated that the combined total assets of India’s wealthy is set to reach around US $ 6.4 trillion( the highest in Asia ) over the next 4-5 years.

India’s demographic profile is very attractive with a strong pool of young population adding to the workforce every year but it must be said that a good percentage of them may not be employable. So the government needs to reform its education sector and also increase the number of good universities and colleges across the country. One way to do it will be to encourage established foreign education institutions to set up campuses in India alongside or in partnership with the local universities and colleges.

As the Indian economy grows it is estimated that around 200-250 million people may be added to the consuming class in the next 7 to 10 years. This presents a huge opportunity to both domestic and foreign companies within Asia and other parts of the world.

 In the short to medium term China will still be at the centre stage like the sun in the solar system driving the interregional growth in Asia and parts of emerging markets. Having said that India’s share is gradually increasing and so is its annual growth rate. It is worth noting that India’s annual GDP growth rate for 2010 was slightly above China according to the recent IMF publications. This does not mean that India will anytime soon match China’s economy in terms of the overall GDP ranking. But both the countries are expected to be major driver of growth for the region and other emerging market economies. Based on this assessment the Intra-Asian trade flow is estimated to grow at an average rate of over 12% year-on-year until 2020 (according to HSBC and Asian Development Bank ) and the series of bilateral free-trade agreements signed recently by both China and India with others Asian countries will significantly boost the regional trade flows. 

However it must be said that said both the countries do face significant challenges going forward. There are some concerns that the Chinese economy is overheating and the increased investments in fixed assets especially infrastructure and real estate which shows no visible signs of slowing down in spite of the tightening measures will hinder the real and required rebalancing of the economy.  The latest Q1 GDP print for 2011 show the economy grew at 9.7% year-on-year which exceeds market expectation and also defy concerns about any slowdown in growth.

Some commentators have also suggested that China’s growth story resembles Japan in the 1980’s and ultimately like Japan the bubble will burst and the country will hit a wall. It is worth pointing out that most of the bold forecasts about China have turned out to be wrong. The funny thing about forecasting and making predictions is if you make enough of them on a regular basis there is a good probability that you may get some right eventually. And with the right marketing skills and a bit of luck you could turn yourself into a market GURU.

Due to its growing economic influence China does attract a lot of attention and there are many economic theories around China. It is worth noting that although China is the world’s second largest economy it still has a very high income disparity and a low per capita income. And unlike Japan in 1980’s the country is still a developing economy and has a decade or more of growth left in the tank. Chinese growth story today resonate more with the U.S. story in the early 1900s when the U.S. went through numerous boom and bust but each time the economy recovered and got bigger.

The market expects the government in Beijing to fast track the implementation of policies that drives up the house hold income in real terms; increase the role played by private sector, and incentivise domestic consumptions among others. Also currency appreciation and a collaborative approach to guard against commodity and oil & gas price volatility may be a useful method to fight against inflation driven by external factors.

The previous strategy under which Beijing encouraged its State owned Enterprise ( SOEs ) to acquire mineral & mining resource assets including Oil & Gas overseas to secure price stability and supply didn’t really deliver the desired result. While state owned enterprise (SOEs) profited from the government’s “equity oil “ strategy  the Chinese consumers and the policy makers didn’t see any real reward. And in the current political turmoil in the middle-east Beijing may have to re-visit the existing strategy and look at ways to increase global co-operation with other resources (including Oil & Gas) dependant countries to create a collective game plan for guarding against supply disruption and greater price stability.

Having said that commodities and oil & gas prices will remain vulnerable to speculation and a significant percentage of the pricing input and price movement of commodities including of OIL & GAS is based on speculation. It is worth noting that the world is not constant but changing where a useless commodity can become relevant overnight driven by innovation and technology. For example Crude Oil was once a useless commodity that became valuable overnight.  Also Bolivia’s Lithium reserves – Lithium is used for the production of batteries and was once considered useless but it is extremely valuable these days and with the explosive growth in hybrid and electric cars the demand is outstripping the supply on a daily basis. So all of a sudden Bolivia is becoming very important in the whole scheme of things. It must be said that evolution, innovation and technological advances are key to sustainability and survival. The saying “Necessity is the MOTHER OF INVENTION “clearly holds TRUE.

India and China together is home to over 2.5 billion people so food and energy security will always be at the forefront of government’s policy. And in line with this policy both India and China have allowed home grown companies to expand capacity by acquiring assets in other emerging markets. Indian Agro companies have acquired and leased various agricultural assets including of farming lands in Argentina, Brazil, Mexico and parts of Africa. India’s agriculture sector is need of serious investments and structural reform including improving farming methods in order to increase its productivity.

China has 10% less arable land than India yet its agricultural production is 25% higher. Also China implemented land reforms in the early fifties which resulted in enhanced agricultural output, establishment of agro industries whereas with the exception of some states land reforms were mostly half measures in India. Bad policies decisions further deepened the crisis and as a result thousands of farmers are committing suicides every year across the country. Having said that private sector in India is making serious investment in the agro based industry and some of them bearing fruits. Going forward the government and the private sector in India will need to work together to boost investments in agro infrastructure as well as upgrading of existing distribution system, irrigation, farming methods and technology.  New Delhi will have to look at liberalizing R&D in agriculture sector, create policies to encourage investments in the agro sector of the economy and this will have to include the much needed land reforms.

China’s ambitious development goals are an official target of reaching a 95 percent grain self-sufficiency rate. This policy is a pillar to establishing the country’s food security, and result in an increase in domestic fertilizer consumption. According to the governments figures China’s national grain consumption will reach 572.5 million tons around 2020, requiring an increase of around 50 million tons in domestic fertilizer production over the next 10 years.  In order to achieve these targets, the government has made clear that it plans to boost investment in agro infrastructure also upgrade existing technologies in irrigation systems as well as seedlings, while improving farming methods and increasing the level mechanisation in the sector.

While both India and China search for a more competent, healthier and sustainable way to develop their economy. They do face similar challenges and one of them is to find a growth model that is inclusive and able to deal with growing income inequality which could potentially create social unrest going forward.

The two great civilizations of the past are finding their way back to the world centre stage as economic powers and in the process reshaping the future of the global economy. Both countries can learn a lot from each other and through collaboration create limitless growth opportunities.

A combined population of 2.5 billion presents a huge market full of abundant opportunities that has a potential of creating a super- highway for growth. And linking to a super growth corridor will allow other countries especially the emerging economies to increase their growth speed limits significantly.  So there is a strong case for companies and economies to have a China- India strategy (aka CHINDIA ) rather than a strategy that focuses only on China or India.

 

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Prognosis: Where Are We Heading?

Posted on August 17, 2010. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , , , , , , |

In the last few weeks some of my friends and colleagues have been very busy debating the global economic situation and trying to figure out where we are heading. GO Figure! Eh…. I so wish I could help them and had answers to all their questions.  But then on a second thought no harm in trying…. right?

Let us look at the last few months to get a good handle of where we are, shall we? To begin with I must say if we look at the events unfolding in the last couple of months there was no dull moment and it has been an action-packed rollercoaster ride which has kept us busy and entertained but this depends on how you look at it.

Shall we do a quick RECAP and look at some of the HIGHLIGHTS of the past few months?

Starting with China we saw Agricultural Bank of China raise a record US$ 22 billion in IPO. It was the world largest IPO, the previous record was held by ICBC- China after raising US $ 21.9 billion in IPO. Although some suggested that the reception for Agricultural Bank of China ( Ag Bank ) was lackluster and the IPO was apparently overvalued but most of the analysts surveyed by Reuters expect the stock to go up to RMB 2.81 relatively quickly.  Up to 40% of the Shanghai offering was sold to about 27 strategic investors including of China Life Insurance, China State Construction among others on a 12-18 months lock-in period. And from the Hong Kong listing a total of around US $ 5.5 billion worth of stocks were sold to Qatar and Kuwait’s Investment Authorities.  It is interesting to note that the bank which was considered by many as technically bankrupt with more than 24% in non-performing loans around 3-4 years ago managed to raise a colossal amount of money and also reported a 40% jump in net profit in the first half of 2010. I wonder how Ag bank’s turnaround reflects on the investors’ confidence especially those reluctant to hold bank stocks and may be other banks could take a leaf from Agricultural Bank of China’s book? .Let’s see.

In the short to medium term the market expects China based banks to raise more money as their balance sheet comes under pressure due to excessive lending to the property market.  The China Banking Regulatory Commission (CBRC) has instructed the Chinese banks to test the impact of a 50% fall in the house prices in major cities across China. This is in addition to an early nation-wide stress test that showed the local banks in China could sustain a fall of up to 30% in housing prices without a sharp increase in non-performing loan ratios.

It is highly plausible that the Chinese Government will continue with its controls to restrain the property market fearful of the social pressure that could arise from a BOOM-BUST in property sector as recently seen in the US and in Japan in the 80’s.  And this is already feeding into the overall demand from things like construction raw materials including of steel, cement etc to household products among others.

Most of the recently published figures show a softening in demand. The annual factory output in July slipped to 13.4 from 13.7 in June although above the consensus but still a decline. The Consumer price inflation fell to 2.9% in June from 3.1% in May. These figures along with the weaker retail sales indicate clearly a slowdown in the economic activities across which was reflected in the second quarter (Q2) GDP numbers. According to the National Bureau of Statistic (NBS )  the growth fell to 10.3% in Q2 from 11.9% in Q1 of 2010. The Q2 GDP print was below the market expectation of 10.5%.

Although there are different view as to where the Chinese economy is heading I believe the GDP and other data are in line with expectations and there is no alarm yet. The slowdown as expected looks moderate and I believe there will be no policy relaxation from Beijing in the immediate future especially based on these set of numbers. So going forward we may see the investments come down and the recent numbers out do point in that direction. Let’s look at them. According to the Central Bank the total loans for the month of July stood at RMB 533 billion, below the forecasted RMB 600 billion, the year-on-year credit growth has also slowdown sharply to 18.4% in July, well down from 33.8% of last year, also the annual growth in the broad M2 measure of money supply considered the lubricant of economic growth slowed to 17.6 percent in July from 18.5 percent in June.

What all this means is we may see further softening in demands in China which will reflect badly on imports including of commodities and machineries etc  going forward.  To add to that we are already seeing a significant buildup in inventories and this is not what you want to hear if you were a German machine manufacturer, a miner or a commodity driven company/economy. Some in the financial markets may worry that the policy makers in China are applying the brakes too hard to slowdown the economy which could take out a big chunk of the existing global demand especially because China has been a major driving force. And this may reflect badly on the overall global growth prospect and recovery.

There is no doubt that the slowdown in economic activities is in line with  Beijing’s  expectation and this is clearly a government engineered slowdown as the market feared an overheating of the economy earlier this year and some analysts even suggested that it may be too late for Beijing to a get grip over the runaway economy. This is why I keep telling my friends and colleagues never underestimate the policy makers in Beijing.

The other side of the story is that the economy is still holding up and even with the current slowdown in activities the consensus view is that China could still grow at 9% or there about in the FY 2010. This is by no mean the end of the world as some may fear. I believe it is worth noting that going forward the government may start to ease its credit policy especially if there are signs that the economy is slowing down too rapidly for Beijing’s liking and so by the end of the year they may speed up targeted investments in areas such as low-income housing, rural development and clean energy. Also we shouldn’t forget that one of the advantages of the existing political system in China is that it allows the policy makers to acts faster and swiftly unlike their peers in other parts of the world.

Staying with Asia the fact is many policy makers across Asia are starting to worry more about inflation and hot money flow than a double-dip. Most economies in Asia including of Hong Kong, Singapore, South Korea, India, China, Indonesia and Australia among others have all seen a very significant capital inflows in 2009 and the first half of 2010 mostly from investors attracted by their growth potential. And now there is a genuine concern that the amount of hot money committed to Asia and Emerging market as whole could create an Asset bubble going forward. In fact European and American equities markets are looking cheaper then developing markets and you wonder if some emerging markets may have already produced most of their gains.  That said the growth story of the emerging markets is still intact and investors looking for growth will remain extremely attracted to the EM.

So far this year Southeast Asian Markets has had a very strong run and as of the end of July, Indonesia was the best-performing market in the world in 2010, the Jakarta Composite Index up 26.2 percent; Thailand’s Main Index was up 19.7 percent; Malaysia’s 14.5 percent and The Philippines’ 13.0 percent. However, Singapore Straits Timex Index was only up by 6.3% in the first half of 2010 despite a second quarter (Q2) GDP print of 19.3% year-on-year. The city-state economy is benefiting from government investment in the bioscience, electronics and construction sectors among others and is expected to grow at around 15% or more in the FY 2010.

Moving on let us look at what’s cooking in Europe shall we?

The recent numbers out from the Euro Zone clearly point to a two faced growth in the Euro area. While Germany the largest economy in the Europe expanded at the fastest pace in over two decades reporting a 2.2% growth in second quarter (Q2) and was responsible for almost two thirds of the Euro bloc’s second- quarter growth but unfortunately its southern European counterparts are still struggling to recover from the CRISIS.

Germany’s business confidence data- Ifo index continues to be on the ascending trajectory showing the strongest increase since the reunification in 1990’s. The unemployment rate in June declined to 7.5 % from 7.7 % in May the jobless numbers was down by 88,000. This was mainly due to the government support for maintaining employees on the job with shorter hours instead of laying them off. The economy seems to be getting in shape and the export driven business model of Germany is in full swing. All the signs show that the Germans export benefitted heavily from the demands coming from Asia especially China but going forward it is highly plausible that the growth may lose momentum because of the strengthening Euro and softening in demands from countries like China. Also in the second half of 2010 the austerity measures will kick in hampering the growth further.

The austerity measures are already crippling growth in countries like Latvia, Greece and Ireland.  Take for example LATVIA –one of the first EU nations to implement austerity measures two years ago. The huge budget cuts have made the matter worst. Also Greece has been hit harder than previously forecasted after implementing the severe austerity measures and it is highly likely that the growth will remain negative for this year hurting the economy even further. According to a recent research published by the retail confederation ESEE about a fifth of small shops in Athens have shut down because of the downturn. The unemployment is expected to go higher from its current 12% level hitting the private consumption further. The ongoing recession is deepening consumers’ insecurities about jobs and debt, making them cut their spending and to try to wind down borrowings. It is highly plausible that the impact will become more pronounced in the second half of 2010.  We will have to wait and see. It is going to be a real test for the voters and politicians.

There is a genuine fear in the market that with the austerity measures kicking in around the second half (H2) of the 2010 some of the European nations including of Spain may slip back into recession after reporting a GDP growth of 0.2% in the second quarter (Q2 ) creating a growth gap and making it harder for the European Central Bank (ECB ) to correctly gauge the timing of its policy tightening steps. As things stand I think it is safe to assume that it’s too early for ECB to start thinking about tighter policies and one should not get carried away with Germany’s second quarter ( Q2 ) growth numbers. The reality is Euro Zone countries are still struggling to keep their head above the water and in most countries across the EU the wage pressure are downwards and the core inflation stand at just 1%. Also besides Germany other major European economies like Italy are struggling with the mountain of debt and raising money for them in the market is not getting any easier as reflected by recent jump in the spreads.  Based on Bloomberg data for the first time since June 28 the premium that investors demand to hold 10-year Greek bonds against a German government bond of same maturity rose to 800 basis points (bps) and the Spanish government bond yields climbed six basis points to 4.24 %.  Most investors are also shunning Spanish banks because of their record borrowing of 130.2 billion euros from the European Central Bank in July of 2010.

It is also worth noting that while Germany is forging ahead the others in the EU believe that it is doing so at their expense. By cutting the budget deficit and keeping the wages down Germany is in fact making it harder for other EU states to regain competitiveness. It will be interesting to see how all this plays out for the Euro Zone going forward.

The hope is that the European leaders will learn from their past mistakes and going forward they will look beyond their national interest and work together towards perfecting the Union. The Union was not designed or conceived to handle a CRISIS it clearly exposed the flaws and also the limits of EU integration and coordination.

Staying with the EU let us also look at the performance of the UK economy, a prominent EU member and a major trading partner, in the last few months.

According to the office of National Statistics the UK economy grew at 1.1% in the second quarter ( Q2 ) of 2010. The Q2 GDP print was well above the market forecast of 0.6% but as per my expectations. I wrote a piece in April of 2010 titled Market Psychology and Investors Sentiment (mood of the market) – The Driving Force Behind the markets “. I have copied an extract from the post which explains the reason behind my assumption.

“ And in terms of growth, going forward we could see a market beating quarterly GDP numbers and the reasons for that is simple we simple don’t know how much spare capacity is left in the economy and the inventories are so LOW that even with the existing and basic demand you will see a pickup in growth and this could PUSH the market up”

So does that mean the UK economy is now getting back in SHAPE?

Well let’s look at the bigger picture to get a better IDEA. A recent survey done by the building society Nationwide puts British consumer morale at the lowest since May 2009.  According to Nationwide the rising food and fuel costs may also have played a part in the drop in consumer confidence indicator from 63 in June to 56 in July. The survey also showed a sharp fall in households’ sentiment about the economy, job market and income over the next six months. Consumers are growing increasingly concerned about their disposable income and the planed VAT rise from January of 2011 probably won’t help that concern going forward.

Also according to the Royal Institution of Chartered Surveyors the house prices fell for the first time in a year in July because of the buyers’ reluctance to commit as the sellers rushed to sell their properties. There is a risk that we may see this softer trend continue in the second half (H2) of 2010 as many prospective buyers are still struggling to raise mortgage finance. I believe it is worth noting that the high profits for banks in the first half of 2010 were also facilitated by lower impairment of existing mortgages and expectations that house prices would be stable. Going forward a slowing housing market along with the planned 25% government spending cuts, VAT rise, and a high unemployment  among others will add to the uncertainty facing the Bank of England as it tries to guess the growth prospects for the UK economy.

The new coalition government in Britain has decided to strip down to its bones as it prepares to cut the expenditures by more than 83 billion pounds over the next five years and drastically shrink its responsibilities. You can’t help but wonder if the economy can survive a starvation diet. Imagine an extra extra extra  large ( XXXL ) size human being decides to SLIM down dramatically and goes on a CRASH WEIGHT loss program. The commonsense tells us that he will SLIM down alright but in the process also runs the risk of crashing his/her heart. A gradual weight reduction is always the best advice which also leads to a long term weight control and a healthy system.

There is no doubt that Britain risks losing it growth momentum due to the planned spending cuts, VAT rise etc. And it is evident from the Bank of England recent downgrading of UK’s growth forecast for the FY 2010 the bank also raised its inflation expectation for the next year in its recent published quarterly growth and inflation forecast.

Staying with the spending cuts here is an extract of what I wrote in one of my post titled Stimulus: The Exit Strategy and the road aheadin January of 2010. I think it is still relevant.

Although one understands that there is need to fix balance sheets (fiscal consolidation) and address the inflationary concerns by having a clearly formulated, defined and coordinated exit strategy in place. But that said Timing will be KEY here as exiting too soon or too late has its own risk. And also it is extremely important that the process should only begin when there is enough hard evidence to see that economy will keep growing on its own after the removal of the stimulus or in other words it is evident that the recovery is solid, financial markets are back to normalcy and credit risk spreads are at an acceptable level and there is a significant risk to inflation over the medium term

In the same post there is another interesting point that I thought I’ll share again.

Here is an extract “ ……………….one has to also admit that the policy makers have managed to avoid a Great Depression type event by not adopting an extremely tight fiscal and monetary policy but a single policy mistake here could jeopardize the whole recovery process “.

I think it is important to point out that both the points are still relevant and we can only hope that the policy makers get it right and have a good foresight.

Moving on it is no secret that the global economy is still very reliant on the US and going forward an underperforming US economy will reflect badly on the overall growth prospect.  So let us check out how the US economy has been doing in the past few months.

The market was anxiously awaiting the Financial Regulation (FinReg) Bill  so the biggest news coming out of the U.S. for some was the passing of the FinReg bill in July of 2010 that is supposedly going to prevent future CRISIS. Whether it does or not well for that we will have to wait and see. The FinReg bill deals with a number of issues. Some of the important one’s are Systemic Risk – Under the proposed plan the Financial Stability Oversight Council chaired by the secretary of the treasury will identify firms that threaten stability of the system and subject them to tighter oversight by the Federal Reserve; Ending Bailouts -Firms would have a mandatory “funeral plans” or a living Will that describes how they could be shut down quickly; Supervising Banks – the Comptroller of the Currency will take over from the U.S. Office of Thrift Supervision and the FDIC’s deposit insurance coverage will be  raised to $250,000 per individual from the current $100,000 level ; Hedge Funds – All Private equity and hedge funds with assets of $150 million or more will need to register with the SEC and will be subject to more inspection. However, venture capital funds would be exempted; Insurance – A new federal agency/office will monitor the industry; Volcker Rule And Bank Standards – credit exposure from derivative transactions will have to be added to banks’ lending limits, Non-bank financial firms under the Fed supervision will now face limits on proprietary trading and as well fund investing etc; And Investors protection among others.

Now coming back to the performance of the US economy in the past few months, the recent data from the US has been mixed and also weak. So let us look at some of them.

 We saw the U.S. consumer-price index increase by 0.3%, the most in a year and above the market expectation. The Commerce Department data showed retail sales excluding autos, gasoline and building materials unexpectedly fell by 0.1 % in July. According to Reuters/University of Michigan survey of consumers the preliminary index of consumer sentiment jumped to 69.6 following a reading of 67.8 in July, the lowest since November. Also the U.S. second quarter (Q2) GDP growth slowed to 2.4%.

Based on the recent data coming out the US it is safe to assume that the recovery is softening.  Taking this into account the Federal Reserve has taken fresh steps to lower borrowing costs. In a recent statement the Fed announced that “ to help support the economic recovery in a context of price stability, the committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities”.  This is a significant policy shift as not long ago the central bank was eagerly debating the EXIT strategy from the huge stimulus delivered during the crisis. The Fed is also downbeat about the growth outlook going forward. A recent San Francisco Fed study suggests that there is a strong chance that the US economy will slip back into recession in the next two years. And to add to that according to the latest IMF’s annual review of the U.S. economy the fund observed that the U.S. fiscal gap associated with current federal fiscal policy is huge for probable discount rates.” And it claims that “closing the fiscal gap will require a stable annual fiscal adjustment equal to about 14% of U.S. current GDP. That basically translate into a constant doubling of personal-income, corporate and federal taxes as well as the payroll if the U.S. was to try to close the current fiscal gap from the revenues. So in short the country is living way beyond its means. Some would term this as a technical bankruptcy. Shocking isn’t it? But this depends on how you look at it. Remember the phrase when the U.S. sneezes the world catches cold well this still holds true so fear not. Also you go bankrupt only if others are not willing to lend you the money. It is in the interest of the world to keep the U.S. economy afloat and going forward it is highly unlikely that the foreign buyers of U.S. treasuries including of China, South Korea, Japan, Taiwan and others will abandon the US.  Although the US economy has performed a bit below the market expectations it will be unwise to write it off and underestimate its ability to come back.  But going forward there may be a significant rise in the poverty level across the U.S. and we are also going to see tax rises among other things.  It is worth noting that the Fed’s still have ammunitions at their disposal but we will have to wait and see how effective they are going to be.

There is no doubt that going forward the policy makers in the U.S. will have to find ways to make sure that credit worthy small and medium size businesses have access to capital. Banks, companies and individual consumers are all economically inter-reliant. So if the financial institutions refuse to provide credit to good businesses because of the fear that other lenders will cut down as well. This will create a shortage of credit hence extending the CRISIS and delaying recovery even more.

So how will all this reflect on the growth prospects in a wider context?

There is no doubt that the emerging markets have been leading the way and in general investors have so far been more optimistic about the emerging markets than the US or Europe. Also it is interesting to note that the performance of the Asian indexes has been reflected in the US and other developed markets. And the demand side of the story has been mostly driven by Asia especially China. Although all the recent data suggests that the economic activities in major Asian economies like China is moderately slowing down that said China, India, Indonesia and others have a lot of growing to do. And going forward a big chunk of the global demand is going to come from the developing world especially China and India. According to the Washington based Inter American Development Bank (IADB) the total economic output from China and India combined together is expected to be around 10 times bigger than Europe’s total GDP by 2040. While China is already a leading trading partner of most developing countries as well as developed nations across the world, India is now adding to the demand side. Going forward India – a commodity hungry country, may very well become a key demand side client for commodity driven economies like Latin America.

Also the economic growth outlook for Africa is improving and going forward the region does have the potential to become a significant growth provider. And it is in the interest of the world to foster growth in the region. The policy makers especially in the developed world should look at Africa as a prospective vibrant market that will create demand and work towards creating a long term partnership with the region. Some European companies especially Portuguese are already tapping into Africa and generating more than 50% of their revenues from the region thus compensating for the loss of revenue from their domestic market.

This is why I keep saying to my friends and colleagues that the fear of double-dip might be good for the markets in the long run as it will keep the policy makers awake and alert fearing a policy mistake here could jeopardize the whole recovery process and the global community will blame them for it. That’s the fun of living in a globalised world where your problem may become mine sooner or later. Also I am starting to think that this CRSIS is an opportunity to rebalance the world and comparing this crisis to the past recessions and deploying the old rules of thumb is probably unwise as today we have a number of other factors including of a very vibrant emerging market that could influence the outcome.

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